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Nervous investors herald more volatile markets

10 November 2017

Nervous investors herald more volatile markets
Private investors with globally diversified multi-asset investment portfolios tend to be quite happy these days. That is, unless they have more cash that needs investing. As the chart above shows, since the last large market correction at the beginning of 2016, investment returns have been plentiful, even for the less adventurous investors. We have written over the last weeks about how private investors are increasingly concerned that current market levels may be marking a high – simply based on their experience that, after a number of good years, not so good years tend to follow.
While we have explained that it is not as simple and that what counts is the direction of travel of the global economy – which remains on a synchronised expansion path – nervousness is spreading. Institutional and other professional investors and research entities are increasingly feeling compelled to debate whether capital markets have got ahead of themselves, and thus are likely to suffer a setback in the near future.
Such debate is good and bad. Good, because it tells us that we have certainly not reached the levels of exuberant overconfidence which regularly occur just before stock markets hit the buffers. On the other hand, it’s bad, because it indicates that there remains a significant lack of confidence that the economic development is resilient and has the ability to generate further increases in growth. Such lack of confidence makes markets prone to overreacting to the slightest bit of less-than-good news from the economy.
After a good 18 months of ever improving economic updates around the world, with even the UK economy proving to be in better shape in the 2nd half of 2017 than many had forecast, it is inevitable that this continuous acceleration cannot carry on forever. In other words, the rate of growth should continue to be positive, but there comes a point when the rate of growth itself flattens out or even slightly declines. For the mathematically inclined, this is a period where we move from the growth rates’ first and second derivative being positive, to only the first derivative remaining positive.
The most potent fuel for investment returns is an expectation of improving, not just steady, growth. If a steadying of the rate of growth is what we can reasonably expect for the coming 3-6 months, but at the same time we anticipate that investors have jacked up asset prices in the past months on the back of an expectation of an ever-improving outlook, then we should expect disappointment, leading to market setbacks.
Unfortunately, we cannot be sure about either of the two assumptions above. For example, the economic council of the German government warned this week that the economy was at a high risk of overheating, as German GDP growth reaches 2%. Only a few years ago, 2% growth was characterised as ‘stall-speed’, which meant that there was an increased risk of imminent recession. It is therefore not unreasonable to argue that there should be further upside potential in economic growth, if the experience of the past has any relevance for the future.
On the side of heightened valuations of risk assets after this year’s strong stock market returns, we cannot be sure that traditional valuation metrics remain valid. Are the various ratios, whose averages we deem a long-term guidance framework, but which were calibrated to ‘normal’ interest rate levels of 5-6%, still relevant, when ‘normal’ interest rates today are not expected to exceed 3‑4%? Current valuation equilibrium levels may therefore - at least until yield levels of past periods return – be higher than historically observed.
Under our investment framework at Tatton, we aim to refrain from jumping to rash conclusions, but rather take a bigger picture into account. This bigger picture informs us that the global economy remains on track and is showing increasing signs of resilience to regional setbacks and disturbances. At the same time, however, we also observe growing levels of anxiety amongst the investment community, who, over the past decade had to experience that rules of thumb of the past are no longer applicable in this post-financial-crisis world of low yields and lower-than-average confidence.
As a consequence, we expect an increased risk of temporary market sell-offs if and when the rate of economic improvement slows, but are also cognisant of a scenario where risk asset valuations have the potential to (temporarily, at least) reach much higher levels without immediately becoming unstable. What supports this latter possibility is the fact that a significant amount of retail investor funds still remain in cash - futilely while waiting for better yields. Meanwhile, central banks are loath to bring these about through aggressive monetary tightening, for fear of undermining the finally returned upward dynamic of the global economy.
This all leads us to be prepared to once again face increasing levels of market volatility, while not losing sight of the state of the economy, which is now far more resilient to capital market upsets than it has been at any point over the past decade. Should capital markets prove to be equally resilient and continue their upward trend, then we will have to become more mindful of the possibility of the forming of potentially dangerous asset bubbles. While that is a somewhat unnerving prospect, at the current rate of change this is unlikely to become truly an issue before the second half of 2018.
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